While even moral hazard hawks generally agree that some sort of government intervention would be needed in the event of financial trouble at Fannie and Freddie, the most compelling reason was that the US, chronically dependent on foreign funding, would be ill advised to treat its money sources badly.

If that was the motivation, it isn’t working. As we and others noted, spreads on GSE debt have risen to 215 basis points over Treasuries, only a tad shy of the pre-Bear crisis level of 238 basis points. And remember, they have reached this stratospheric levels despite the Paulson rescue package, despite an alphabet soup of new Fed facilities that accept GSE paper as collateral (as the discount window did) now in place (although there were raspberries all around for the bailout bill, due to its failure to make any changes in the operation, management, or policies of the GSEs and its lack of specificity as to triggers and what mechanism would be used).

And the reason? A big factor is that foreign central banks are exiting GSE debt and have pulled back significantly from purchases of new paper. This vote of no confidence appears likely to force the Administration’s hand and lead it to take more concrete measures to prop up Freddie’s and Fannie’s balance sheets. They are not about to risk a spike in mortgage rates and further trouble in the housing markets with elections approaching.

An extraordinary Treasury capital infusion may be needed to restore faltering foreign demand for debt issued by Fannie Mae and Freddie Mac, the two top home funding sources that the government is willing to rescue to save the housing market.

The companies rely heavily on overseas investment, often up to two-thirds of each new multibillion-dollar note offering, to help pare funding costs and keep mortgage rates low.

But foreign central banks have dumped nearly $11 billion from their record holdings of this debt in four weeks, to $975 billion, and won’t return in force before it’s clear if — and how — the government will back Fannie and Freddie, some analysts say….

The bonds these companies issue in the $4.5 trillion agency MBS market are near or worse than the weakest levels, set in March before the government engineered the sale of failing Bear Stearns to JPMorgan.

“People are concerned about whether there’s a bailout that’s going to be coming from the U.S., so it would be logical to see foreign investors pull out of agency paper,” said Kevin Chau, forex analyst at IDEAglobal in New York.

“They don’t know whether the U.S. is going to be committed to supporting the GSEs, and if they are going to support them, by what methods are they going to support them.”….

Overseas investors took an atypical back seat in Fannie Mae’s three-year note sale this week.

Central banks bought just 37 percent of the $3.5 billion issue, down from 56 percent in May’s $4 billion offering of the same maturity. Asia accounts took just 22 percent of the notes, down from 42 percent in May….

“Most fixed income investors to whom we have spoken believe that a capital infusion by the government into Freddie and Fannie is a prerequisite for turning sentiment around in mortgage-backed securities and, by extension, in the broader fixed income markets,” Barclays Capital analysts Rajiv Setia and Philip Ling wrote in a report.

A $10 billion to $15 billion infusion for each government-sponsored enterprise (GSE) is seen doing the trick….

As mortgage bonds trade poorly while investors wait for good news on Fannie and Freddie capital, U.S. mortgage rates have climbed to their highest levels in a year.

It took severe measures to restore investor confidence at various times during the year….

In July, the Fed and Treasury agreed to backstop the two companies if needed, and Bush approved the measures as part of a new housing act on July 31.

However, the initial optimism about the plan has been doused by concern about the government’s follow-through… “It would take something dramatic for there to be a material improvement in the confidence necessary to bring foreign investment back to these agencies at the levels we’ve become used to,” [Michael] Woolfolk [senior currency strategist at Bank of New York Mellon] said. “If not the cash injection, then (we need) an overhaul.”

Update 8/18, 10:00 PM: A reader pointed out that the post creates the impression that the 215 basis point spread applies to all GSE debt, meaning GSE guaranteed MBS as well as their own corporate debt. The 215 figure applies only to the MBS, which is more significant from an economic standpoint, since that influences mortgage rates and the amount outstanding is also considerably larger (ie, a price deterioration will have a greater aggregate impact).

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21 comments

I can’t think of a single reason why foreign CBs should throw their capital away buying GSE debt. Major losses on existing MBSs are locked in. Existing equity in these corps is going to get greased. Even if the Feds step in to guarantee the GSEs own paper its sure to trade at distressed levels for long to come even if it finishes in the money.

At some point it will be brought home to our public financial leadership that stiff upper lips, manful statements, and dry ice fog just do not constitute a PLAN let alone a solution. The recent hack job rush statue, the We [Heart} the GSEs Bill, does nothing to protect buyers of their debt from risk or loss. The crew in the District would love to kick this can down the road into the next Big Guy’s yard, but that isn’t going to happen.

Russia, who has a large portfolio of the agency paper, not only has no reasons to buy more, but might be tempted to dump what it’s got to show its displeasure with the White House around Georgia and Poland

Perhaps the Treasury, creative as ever, might allowFannie and Freddie to auction off their DEFERRED TAXCREDITS, which total 64 Billion, to raise capital? I’msure there are a few oil companies which, if it were allowed, would bid.

Now we know why the ESF has intervened over the past 6 weeks, selling Euros and buying the USD. While the action serves many functions, not least of which is extracting Trichet from his policy mistake, and making the USD more stable for inward investment, it fits in well with making up the new deficit of inflows into the USD.

The USD has been supported in a concerted cross-Atlantic action designed to make the USD stable and attractive to investors in US treasuries and agencies. Sadly, however, once this becomes more clear, it could give fresh momentum to the next down move, in the USD.

While there are many bad things about having a weak USD–the bad things that could come from the a stronger USD are even more numerous.

But let’s make it simple: the USD will stabilize at LOWER levels as long as our exports stay strong. If intervention artificially strengthens the USD it will be both premature, and damaging to the attempted healing process already underway.

USD long is a trade. And nothing more. Those trading it long had better have a quick finger on the trigger, b/c 2.00% FF leaves virtually no cushion for a new reversal.

If Russia, China, et al decide to stop buying GSE debt, Paulson will be auctioning off grandma’s underpants, since there is precious little left of value. If foreign CBs decide to dump enough of their holdings to cause havoc just before the elections, who could stop that tide?

Anyone have an explanation as to why foreign CBs would even want this stuff? We’ve known that Freddie and Fannie have had financial irregs and bloated compensations most of this decade. Despite any “guarantee” it’s too much money, no one could cover that bet. You don’t even get good PR from, just seen as a “threatening foreigner” come to swoop in and buy America.

“Anyone have an explanation as to why foreign CBs would even want this stuff?”

Whenever anyone asks me this i try to point out how difficult a task it is to try to invest 1.3 TRILLION dollars. How many markets can absorb an investment of this size without pushing it to the stratosphere?

There is the us bond market, the us real estate market (to the extent it is securitized) and the us equity market.

as long as USD remain the currency for oil trade, it will be supported by countries who want to maintain a reserve for their oil purchase(india is one example).

USD will remain the currency of oil trade as long as usa has their military in middle east.(which is going to be true till oil stops flowing from middle east).

so oil exporting countries have no other option but to park their oil money in US treasuries(or any USD assets) to stop its depreciation, since that eats away their oil profit and reduces the value of their current USD holdings.

same with exporting countries like japan,china etc….who have a ton of foreign reserve in USD.

till 2 years back USA was the strognest/most-stable country in the world, hence everyone kept their surplus parked in USD assets because it was considered safest investment.

that was the reason why we had easy access to credit in the first place leading to this massive debt load we are currently under.

so we were funded by all this foreign entities to have a good time, and now they cannot withdraw support to USD because that will reduce the value of their holdings.

at the same time exporting countries have no option other than to keep exporting to usa to keep full employment in their country, in other words they want to sell stuff even if we dont pay them back….because it keeps employment low in their country (china is an example).

so in conclusion i am not too worried about interest rates going up a lot and USD collapsing.

Aramu, the interdependency theory has been on the table for sometime. My observation is that Saudis et al as investing their petro capital in very large scale infrastructure projects in their own territory in anticipation that the this finite resource called oil will eventually run out.

The two main reasons that foreign CB’s invest in treasuries and, to a lesser extent agencies, are simple. First and foremost, the foreign CBs have had two political objectives: military protection for CBs of the oligarchies in the middle east (and CBs of some of the Asian mercantilists), and subsidization of export jobs/infrastructure for CBs of the Asian mercantilists. Buying up US dollar denominated securities achieves these objectives by providing cheap financing for US consumers to buy products and the US government to make it easuer for the US to finance the US military. Second, as M noted, the easiest way to invest in US dollar denominated securities is in US treasuries and agencies because the markets are so deep and liquid. The instruments are over-priced delivering a poor return, but we’re looking at buyers with political objectives, so that is irrelevant. And that is buy private, foreign buyers of US treasuries and agencies have been declining over the past several years.

Sooner or later this will end, but who knows when? Maybe China (or someone else) builds up enough trust-worthy military power for the Middle Eastern oligarchs to prefer it as a patron to the US government? Maybe some genius develops a cheap source of energy as a substitute for oil? Maybe enough middle-class consumers develop in Asia (or elsewhere) to support the manufacturing infrastructure the Asian mercantilists have built up. Maybe there’s a big war destroying a lot of the labor or infrastructure in Asia (or elsewhere).

The weekly financial newspaper said that such a move could wipe out existing holders of the agencies’ common stock, with preferred shareholders and even holders of the two entities’ $19 billion of subordinated debt also suffering losses.

An insider in the Bush administration told Barron’s that Fannie and Freddie “are being jawboned” by the Treasury Department and their new regulator, the Federal Housing Finance Agency (FHFA), to raise more equity.

THe lesson we have learned is that it is dangerous to reach for yield.

If you are a central bank, why risk losing capital for 200 lousy basis points? If you really want to earn a higher rate of return over Treasuries, you can purchase legitimate triple AAA corporate bonds.

Why anyone would want to touch Agency debt is beyond me, other than just for pure, unadulterated GREED.

For those that say foreign CB’s recycle USD’s into treasuries and agencies to support consumption through low U.S interest rates and higher residential real estate prices supported by artificially low mortgage rates, you are correct Asia is pursuing mercantilist policies.

Unfortunately, this game has run its course and in the process destroyed the American balance sheet.

I want to extend a warm smile at all the foreign central banks that allowed the American consumer and government to choke on debt off all kinds.

He did offer one suggestion: “The most effective initiative, though politically difficult, would be a major expansion in quotas for skilled immigrants,” he said. The only sustainable way to increase demand for vacant houses is to spur the formation of new households. Admitting more skilled immigrants, who tend to earn enough to buy homes, would accomplish that while paying other dividends to the U.S. economy.

yehbut, one of the corporate-fascist party’s “fundamental” platforms is that “those people” are the primary cause of `mericas problems. Without “those people” to scare the majority ethnic group, what ELSE would the corporate-fascist party have left? “Those OTHER people” or the fornication harlots? Tough to win an election on just “those people” now. The peasantry of the majority ethnic group needs LOTS of “those people” to fear in order to vote corporate-fascist. Allowing more immigration was never an option.

I think Michael Hudson made the argument in the early 1970s and then again in 2003 that the world is on a ‘U.S. Treasury bill standard’ that, by my recollection, means a process of dollar recycling in which surplus nations, in order to keep their economies turning over, have no choice but to fund U.S. deficit(s).

Progressively greater recycling is a quantitative which drives towards and into qualitative systemic change. This process has no national border but uneveness. House price bubble, its breaking down and perverse struggle to perpetuate unaffordabilities for the greater good of long overdone financialization may mark the ending of above mentioned standard. (and quite a bit more).

The real question is what else is Paulson offering those central banks as inducement to hold GSE debt? As Enron demonstrated and Fannie/Freddie has proved, these wink-and-nod agreements are the true problem. You can bet Paulson is the link between the US gov’t, Wall Street and foreign central banks. Who knows what deals he’s cooking up between these three entities.